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-----Original Message-----
From: HBernst963@xxxxxxx <HBernst963@xxxxxxx>
Subject: Re: Re[2]: GEN: TC2000 A/D Line Revisited
>Thanks for sending the chart. I see what you mean. How do you account for
the
>downward bias in this AD line? All the averages are well above their 1987
lows
>and this AD line continues to trend lower every year. What gives and how
>useful can it be with such a bias?
I think the AD line is slowly but surely becoming a useless indicator for
finding market tops. I say this for three reasons, which can be seen by
comparing the S&P to the Russell 2000 (R2K).
1. More and more people are finally seeing the light and realizing the vast
majority of mutual fund managers can't even match the S&P (let alone surpass
it...). They are therefore putting more of their investment dollars into
S&P index funds. This causes two problems. A lot of people think the R2K
is composed of the 2,000 largest companies, it isn't. It is actually
comprised of the 2,000 next largest companies after the biggest 1,000 are
removed. What this means is there is zero overlap between the R2k and the
S&P. Therefore, any money going into S&P index funds is precluded from
going into R2K stocks. Furthermore, the S&P is market cap weighted, which
means the majority of money flowing into S&P index funds goes into just a
handful of the biggest stocks. This just causes the big to get even bigger.
2. There is an inherent bias against the R2K. One of the darlings of the
S&P over the last two years has been Cisco. Over those same two years Cisco
has purchased 13 small but very promising companies, many of which were
trading on the R2K at the time. It's entirely possible that all 13 of these
companies would have appreciated significantly in value, and helped to carry
the R2K index to new highs, but now we'll never know because they're now a
part of Cisco. That's also 13 companies that would have helped to push the
A/D line higher, but now can't. The point is, the "good" companies within
the R2K get bought out, leaving more and more "bad" companies within the
index. This bias has always existed, but it has certainly been greatly
enhanced over the past 2 years, because large companies have been using
their appreciated stock more and more to make acquisitions. Since this
buying spree by the large caps shows no sign of slowing down, this negative
bias against the R2K and the A/D line will continue.
3. In addition to the negative effect of the S&P index funds on the A/D
line already mentioned, the actively managed funds are also making the
problems worse. On the surface, you would think that the fact that so much
money is going into the largest 500 companies through the index funds would
give the managed funds a field day with smaller but promising companies, but
it doesn't. Although the percentage of money going into index funds has
gone up, in absolute terms the size of managed funds has gone up as well.
The problem this has created is that there is simply no way a fund the size
of Fidelity Magellan can take positions in small caps without getting killed
on the slippage when both buying and selling the stock. Any advantage in
buying these "undervalued" stocks would disappear on the transaction.
There's simply too much money being moved in and out. This means even the
managed funds have an inherent bias towards making the big bigger and the
small smaller as well.
I think the classic Dow theory analysis of transports vs industrials still
carries some weight (because most of the transport stocks are pretty large).
Since the transports have not made a new high while the industrials have, it
does raise some concern. However, unless I'm doing my math wrong, the
transports and the industrials have gone up almost the exact same amount in
percentage terms since their October lows (the transports just dropped more
in the first place). When you take that into account, the divergence
doesn't look so dangerous.
Bruce
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